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Dynamic Trading with Predictable Returns and Transaction Costs

  • Nicolae B. Garleanu
  • Lasse H. Pedersen

We derive a closed-form optimal dynamic portfolio policy when trading is costly and security returns are predictable by signals with different mean-reversion speeds. The optimal strategy is characterized by two principles: 1) aim in front of the target and 2) trade partially towards the current aim. Specifically, the optimal updated portfolio is a linear combination of the existing portfolio and an "aim portfolio," which is a weighted average of the current Markowitz portfolio (the moving target) and the expected Markowitz portfolios on all future dates (where the target is moving). Intuitively, predictors with slower mean reversion (alpha decay) get more weight in the aim portfolio. We implement the optimal strategy for commodity futures and find superior net returns relative to more naive benchmarks.

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File URL: http://www.nber.org/papers/w15205.pdf
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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 15205.

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Date of creation: Aug 2009
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Publication status: published as "Dynamic Trading with Predictable Returns and Transaction Costs" (with Lasse Heje Pedersen). Journal of Finance, vol. 68 (2013), issue 6, pp. 2309-2340.
Handle: RePEc:nbr:nberwo:15205
Note: AP
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  1. Acharya, Viral V & Pedersen, Lasse Heje, 2003. "Asset Pricing with Liquidity Risk," CEPR Discussion Papers 3749, C.E.P.R. Discussion Papers.
  2. Ricardo Lagos & Guillaume Rocheteau, 2006. "Search in asset markets," Working Paper 0607, Federal Reserve Bank of Cleveland.
  3. Markus K. Brunnermeier & Lasse Heje Pederson, 2003. "Predatory trading," LSE Research Online Documents on Economics 24829, London School of Economics and Political Science, LSE Library.
  4. Anthony W. Lynch & Pierluigi Balduzzi, 2000. "Predictability and Transaction Costs: The Impact on Rebalancing Rules and Behavior," Journal of Finance, American Finance Association, vol. 55(5), pages 2285-2309, October.
  5. Campbell, John Y. & Viceira, Luis M., 2002. "Strategic Asset Allocation: Portfolio Choice for Long-Term Investors," OUP Catalogue, Oxford University Press, number 9780198296942, March.
  6. Dimitri Vayanos, 1998. "Transaction costs and asset prices : a dynamic equilibrium model," LSE Research Online Documents on Economics 451, London School of Economics and Political Science, LSE Library.
  7. Lars Ljungqvist & Thomas J. Sargent, 2004. "Recursive Macroeconomic Theory, 2nd Edition," MIT Press Books, The MIT Press, edition 2, volume 1, number 026212274x, June.
  8. Andrew W. Lo & Harry Mamaysky & Jiang Wang, 2001. "Asset Prices and Trading Volume Under Fixed Transactions Costs," NBER Working Papers 8311, National Bureau of Economic Research, Inc.
  9. John Heaton & Deborah Lucas, 1993. "Evaluating the Effects of Incomplete Markets on Risk Sharing and Asset Pricing," NBER Working Papers 4249, National Bureau of Economic Research, Inc.
  10. Bruce Ian Carlin & Miguel Sousa Lobo & S. Viswanathan, 2007. "Episodic Liquidity Crises: Cooperative and Predatory Trading," Journal of Finance, American Finance Association, vol. 62(5), pages 2235-2274, October.
  11. Balduzzi, Pierluigi & Lynch, Anthony W., 1999. "Transaction costs and predictability: some utility cost calculations," Journal of Financial Economics, Elsevier, vol. 52(1), pages 47-78, April.
  12. Bong-Gyu Jang & Hyeng Keun Koo & Hong Liu & Mark Loewenstein, 2007. "Liquidity Premia and Transaction Costs," Journal of Finance, American Finance Association, vol. 62(5), pages 2329-2366, October.
  13. Longstaff, Francis A, 2001. "Optimal Portfolio Choice and the Valuation of Illiquid Securities," Review of Financial Studies, Society for Financial Studies, vol. 14(2), pages 407-31.
  14. Jean-Luc Vila & Dimitri Vayanos, 1999. "Equilibrium interest rate and liquidity premium with transaction costs," Economic Theory, Springer, vol. 13(3), pages 509-539.
  15. Hong Liu, 2004. "Optimal Consumption and Investment with Transaction Costs and Multiple Risky Assets," Journal of Finance, American Finance Association, vol. 59(1), pages 289-338, 02.
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